UBS research focus

Wealth Management Research June 2012

North American energy independence: reenergized

Energy self-su ciency boosts US economy and manufacturing competitiveness Transport and utilities evolving to make greater use of cheap natural gas US to end dependence on OPEC and transition to renewables

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North American energy independence: reenergized

Pipes at a natural gas processing plant in Colorado signal expansion of infrastructure and a boon to the US economy.

2011 Outlook

EditorialDear readers, The surge in crude oil and gasoline prices during the rst quarter of this year angered consumers and politicians and served as an unwelcome reminder of our dependence on energy. With no immediate relief available, US motorists had to dig deeper into their wallets. However, a positive trend emerged: the sharp decline in the price of domestically produced natural gas enabled American households and businesses to save on their electricity and heating bills.Mike Ryan

The same technology that has unleashed an abundance of natural gas has also unlocked previously unrecoverable supplies of crude oil throughout North America. For the rst time in decades, the US has actually reduced its dependence on foreign energy sources a trend that will likely continue. This movement toward greater energy independence and use of inexpensive natural gas will yield numerous advantages for the US economy, particularly as it boosts domestic manufacturing competitiveness and slows the ow of dollars overseas to pay for imported oil. Moreover, the enormous infrastructure development needed to adequately service this evolving energy landscape should li investment spending and hiring in the oil and gas sector and in other peripheral industries. US natural gas is not only cheap relative to crude oil, it is also much less expensive than elsewhere in the world. We expect power utilities, petrochemicals companies and eventually the transportation grid to use more natural gas. As high pump prices continue to crimp consumer spending, Americans will shi to more fuel-ef cient, electric and other alternatively powered vehicles. But while dependence on foreign oil shrinks, energy security will remain out of reach as long as renewables comprise such a small share of US energy consumption. However, we believe greater energy self-suf ciency and more a ordable fuels also set the stage for further transition to renewable fuels down the road. This edition of UBS research focus explores North American energy independence both the obstacles and the opportunities. In an accompanying UBS research focus recommendations report, we outline how sectors and companies could be a ected by a move toward energy independence. In addition to identifying investment opportunities for your portfolio so you can capitalize on this theme, we also highlight the practical bene ts of greater energy selfsuf ciency on our daily lives, so the next oil price spike doesnt cause as much pain.

Mike Ryan, CFA

North American energy independence: reenergized June 2012

Highlights

North American energy independence: reenergized

North America will likely achieve energy inde US oil consumption to continue to pendence by the end of the decade. The decline, as the comparatively high price of American energy extraction techniques of horioil will likely prompt drivers to switch to more zontal drilling and hydraulic fracturing comfuel-ef cient vehicles and alternative powbined with a structurally high relative price of ertrains, such as hybrids and electric vehicles. crude oil has encouraged widespread development of Americas energy resources. Natural Increased use of natural gas at power gas is so oversupplied in the US that developplants that have long relied on coal. Natural ers are curtailing production, while domesgas will also nd its way into the transportic oil producers are working to circumvent tation fuel mix through use of compressed infrastructure bottlenecks to transport their natural gas and other natural gas technolosupplies to re neries. As a result, natural gas gies in eet vehicles, as well as through the in North America costs less than a h of the wall outlet for plug-in electric cars. cost of oil on an energy-equivalent basis. Demand for renewables to hinge on Over the next several years, we expect: government subsidies, which may come under pressure in an age of heightened Americas newfound energy resources austerity. to provide a much-needed boost to US economic activity, as the country con Intense pressure on the global energy tends with the e ects of widespread debt industry to keep pace with demand. The deleveraging. UBS economists project a Energy Information Administration projects a roughly 0.5 percentage point intermediate58% increase in energy demand by 2035 on term boost to US real GDP. The drivers account of rising consumption in emerging behind this growth spurt include exploramarket countries. Despite an increase in the tion, development and infrastructure investuse of renewables, fossil fuels still account ment, direct and indirect job growth from for over 80% of the global energy mix; and energy extraction, and the windfall that will energy producers must race to even more likely accrue to households and businesses remote locations to secure supplies. In the from relatively lower-cost fuels. case of oil, many of these supplies are in the hands of national oil companies, which even further hinders supply security for countries Relatively inexpensive natural gas to dependent on oil imports. create a competitive advantage for the US. This is another key factor supporting our view that the US economy will experi The US to eventually wean itself o ence a manufacturing renaissance through OPEC imports, through a combination of the repatriation, relocation and expansion of lower oil demand, greater domestic proenergy-intensive industrial operations. This duction and additional Canadian imports. trend is especially powerful for the petroNot only will North America achieve greater chemical and materials sectors. self-suf ciency and energy independence,

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Reengergized

but we expect the US will also become a net exporter of natural gas later this decade. A lower structural trade decit to result

con ict in the Middle East, will also encourage a shi away from imported oil from the region. Fossil fuels will not go the way of the dinosaur anytime soon, however. The US must continue to pursue e orts to develop technology and increase the availability of renewables in the nations fuel mix to ensure maximum energy security. True energy independence means consumers can no longer be held hostage to either the fuel suppliers or the supplies. To truly break free of its tried-and-no-longer-true energyinef cient ways and means, the nation must embrace renewable fuels the next step on the path to complete independence.

from a moderation in oil imports and an acceleration in natural gas exports. Some of the US dollars previously shipped overseas for imported oil will now be spent on domestically produced energy or be freed up for other spending because of inexpensive natural gas and expected ef ciency gains. The trends we discuss in this report are primarily a function of market-based incentives to change behavior. Energy policy, especially e orts to reduce harmful pollutants, lower greenhouse gas emissions and raise fuel ef ciency, will also spur changes in the fuel mix away from oil and coal and toward natural gas. Geopolitical events, especially the potential for

Energy North American energy independence: reenergized June 2012 3 North American energy independence: reenergized June 2012 3

The North American energy landscape has been irreversibly transformed. Whereas US oil and gas production once lay at the fringe of the energy discussion, it now takes its place right at the center. For the rst time in over a decade, US energy production is rising thanks to the formerly untapped potential of shale oil and gas reserves. New drilling techniques are behind a spectacular rise in onshore activity all around the US. The advent of horizontal drilling and hydraulic fracturing has heralded a modernday gold rush of sorts. The number of horizontal rigs at work in the US illustrates the point. According to Baker Hughes, there are 1,177 horizontal rigs currently working onshore in the US. At the beginning of the last decade, there were 48. The shale revolution began with natural gas early in the last decade. Where shale gas production accounted for just 2% of the total US natural gas production in the early 2000s, it now represents more than 30%. The US had been preparing to import more natural gas, building several new port facilities along the coasts. Now it looks as though the direction of natural gas will reverse as the US transitions to an exporter of natural gas. For how long has US dependence on oil supplies from the Middle East been an American pet peeve? The US is on track to eliminate

imports from the Middle East by the end of this decade. Oil production in the US has risen by over 1 million barrels per day (b/d) in the last ve years virtually all of this from onshore production in the lower 48. Surprisingly, North Dakota is now second on the list of top oil producing states behind Texas but ahead of Alaska. All of this is good news for the US. But like any story about energy, this one has its fair share of caveats. Environmental concerns are chief among them, but they are all surmountable. America also heavily relies on fossil fuels. That said, abundant supplies of shale gas now challenge the coal industry and raise the economic bar for renewable technologies. America is now reenergized. It is a story worth following.

Due to the technical aspects of this story, weve provided an informative glossary of terms used in this report starting on page 35.

June 2012 UBS research focus

Chapter 1

Americas new energy diet: lean and green

Americas newfound abundance of oil and natural gas comes amid sharply higher global energy demand and structurally elevated oil prices. As a result, important shifts are under way to diversify the US fuel mix and improve e ciency. As transport becomes leaner, oil consumption will decline. Meanwhile, eet vehicles will steadily use more natural gas, as will power plants. Together with increased use of renewables, the US is moving along the path to greater energy security and self-su ciency.Kurt Reiman, Head, Thematic Research Wealth Management Research; Nicole Decker, Analyst

Addicted to oil Since the early 1950s, the US has had to increasingly rely on imports to meet its steadily growing appetite for energy (see Fig. 1.1). Nowhere has this been truer than in transportation: Although the US is mostly self-suf cient in the energy used to power industrial, commercial and electricity generation facilities, Americas transportation network is overwhelmingly dependent on imported oil to shuttle around suburban commuters, fuel

larger cars and accommodate more drivers and airline passengers.1 The reason: The vast majority of US energy imports are in the form of crude oil, and the nations vehicle eet is almost entirely dependent on oil for power (see Fig. 1.2 and Fig. 1.3). Americas oil addiction has yielded numerous disadvantages over the years. Most painfully, Americans must once again contend with higher prices at the pump an unwelcome

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June 2012

burden when households are trying to burn o mountains of debt accumulated during the real estate boom (see Fig. 1.4). With plentiful domestic reserves of cheap natural gas and now-viable sources of oil, Americas reliance on imported oil, especially from volatile sources, seems all the more absurd. Therefore, Americas energy challenge is to use this newfound oil and natural gas as an opportunity to achieve greater energy self-suf ciency. A conuence of powerful forces But how? Many believe that the US can only achieve energy independence through a coherent mix of energy policies and regulations. We disagree. Although policies are important for changing behavior and moving the country in a new direction (see box on page 15), we think economic and market-driven forces are the primary catalysts behind America further capitalizing on its domestic energy resources. In addition to economics and policies, geopolitical forces will also play an important role. Economic and market-driven forces Continued worldwide growth in energy demand will deepen ongoing supply challenges. Rising emerging market oil consumption, together with declining output growth, has kept the oil price elevated. This dynamic, which we expect will persist, bolsters the development of costlier crude oil reserves to meet rising global demand (see Fig. 1.5). Onshore US energy reserves are transform-

ing the domestic energy industry. North American energy resource discoveries and advances in drilling technology, spurred by structurally higher oil prices, have yielded economically viable domestic and regional supplies of oil and natural gas to meet a larger share of the US long-term energy needs. Development of domestic energy reserves

creates jobs directly, but the deployment of

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Americas new energy diet: lean and green

relatively inexpensive natural gas (see Fig. 1.6) o ers a potential cost advantage to US industrial and manufacturing businesses, which would also indirectly support job creation. Not only is the US dependent on foreign

energy imports, Americans also have a relatively higher dependence on energy in their daily lives than people in other developed countries.2 Continuing to improve energy ef ciency in transportation, business and household consumption is perhaps imperative in a debt-constrained economic environment as a way of controlling costs and maximizing income and productivity. Policy forces Deleveraging of balance sheets in the US, and the resulting slow-growth environment, shi s the discussion toward policies that promote jobs and investment in the natural resources sector, as well as policies that appropriately weigh both the costs and bene ts of environmental concerns. Central banks are likely to keep monetary

policy accommodative for as long as possible during this era of deleveraging, which, all else being equal, could bolster the price of oil and other commodities. In addition to supporting the development of unconventional reserves in North America, structurally high oil prices promote enhanced ef ciency measures and advances in renewables technology. The US has shouldered a gaping trade de cit

for decades the principal components of which are de cits with China and oil-exporting countries (see Fig. 1.7). To the extent that a persistent and large trade de cit is seen as a weakness, policymakers may support e orts to bring the trade de cit closer to balance through reduced imports of crude oil and exports of natural gas.

1990

2010

Source: BP Statistical Review of World Energy 2011, UBS

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Chapter 1

Geopolitical forces A geopolitically sensitive period highlights the need for greater energy self suf ciency (see the July 2010 UBS research focus, Geopolitics: the blind side). Geopolitical instability and concerns about supply interruptions, particularly in the Middle East, have added to the price pressure and volatility in oil markets, which are likely to persist.3 Although there is no practical way to completely insulate the country from these

shocks, since oil prices are set in global markets, reduced dependency on volatile supplies would likely so en the economic impact if crisis erupts. Therefore, North America has an incentive to become energy independent and bring new reserves onboard. The US faces structural competition for

A growing global appetite for energy

Energy has been plentiful and cheap for so long, especially compared to human e ort, that we now take it for granted. Not only do we use it in ways that are highly inef cient, we assume that producers will supply more of it consistently over time to meet our needs. However, there are no guarantees that future energy supplies will be available in suf cient quantities and at an a ordable price. A er all, only about 13% of global energy consumption in 2010 was renewable, according to ExxonMobil (see Fig. 1.9).4 The amount of energy the world consumes today is simply staggering. Putting this amount of energy in a way that can be easily grasped is a dif cult exercise. But perhaps the following examples can help: To show just how far society has departed

from early civilization, we calculated how long it would take for people to generate the equivalent of todays annual energy consumption. Scientists have estimated that the average person produces energy at a sus-

Source: ExxonMobil, UBS

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US and China will seek to secure energy resources from overseas, and also look to develop domestic resources, whether they be renewable or traditional fuels. Since both are so heavily dependent on foreign suppliers, greater energy security for both nations would not only limit the potential for geopolitical con ict, but could pave the way for more stable global economic growth. In fact, Chinas thirst for energy could present an opportunity for cooperation if US compa-

nies were able to license their shale oil and gas extraction technology to enable Chinas domestic production. US energy independence? Has Americas energy de cit grown so large that US energy independence is simply out of reach? Probably, but another strain of this theme North American independence seems attainable. The path involves some combination of the following:

tained rate of one-tenth of a horsepower.5 We estimate that it would take the worlds 4.3 billion working-age people almost 250 years to produce the amount of energy consumed globally in just one year. Global consumption of fossil fuels (coal,

natural gas and crude oil) is equivalent to approximately 210 million barrels of oil per day.6 It would require the daily oil production of 19 Saudi Arabias the worlds largest oil producer just to reach one day of the worlds oil demand. The Alaska National Wildlife Refuge (ANWR)

53% between 2008 and 2035.8 Importantly, the appetite for energy among developed countries is poised to level o while energy demand in emerging markets will likely grow strongly alongside rising incomes and growing populations. The question is more about just how fast energy demand will grow in emerging markets. For now, the EIA expects energy demand within Organisation for Economic Co-operation and Development (OECD) countries to expand by only 18%, whereas consumption is forecast to grow 85% in nonOECD countries (see Fig. 1.10).

holds 10.4 billion barrels of oil (the midpoint estimate of recoverable oil reserves).7 This resource would be depleted in just over a month and a half by the worlds energy demand. In other words, if taken in isolation, the global energy industry would need to discover a eld the size of ANWR every 50 days just to meet the worlds energy needs as expressed in oil terms. Despite the already enormous appetite for energy, most forecasts call for a sustained increase in worldwide energy demand over at least the next decade. The US Energy Information Administration (EIA) projects global primary energy demand will grow

North American energy independence: reenergized

Reduced crude oil consumption through

the development of substitute vehicle powertrains and fuels, improved automotive ef ciency and less overall demand Increased domestic production of crude oil

structurally high oil and gasoline prices (see Fig. 1.11). In fact, a er years atop the global energy consumption charts, the US slipped to second place in 2010, with China overtaking the number one spot (see Fig. 1.12). Weaker US energy demand growth makes North American energy independence all the more possible, while strong emerging market demand makes it all the more necessary. In our view, the demand channels that will have the greatest e ect on improving US energy security are Energy substitution from both oil and coal to natural gas, as well as from fossil fuels to renewables Energy ef ciency Energy substitution: oil to natural gas The transportation sector o ers the greatest potential for oil-to-natural-gas substitution. Although low natural gas prices and high gasoline prices make this an obvious candidate for switching, relatively few customers have made the transition (see Fig. 1.13). While competitive on the basis of price, natural gas demand within the transportation grid is unlikely to take o without distribution networks, refueling facilities and vehicle engine retro ts.

and natural gas

Improved infrastructure for the transport and

use of North American natural gas and crude oil in the form of re neries, pipelines and lling stations, as well as changes and improvements to electricity generation and distribution, such as the build-out of smart grids Increased use of renewable fuels through

technological advances and cost reductions Before diving into the supply side of the energy equation, we will rst take a look at how demand shi s can enhance US energy self-suf ciency. A leaner, greener path lies ahead US demand is likely to remain anemic over the next several years, thanks to a protracted phase of domestic debt deleveraging, slowing population growth, improved auto fuel ef ciency, increasingly ef cient industrial operations, and

June 2012 UBS research focus

Americas new energy diet: lean and green

For now, most of the oil-to-natural-gas vehicle conversion activity is taking place among companies and municipalities that can refuel vehicle eets at a central location. Still, the cost to convert a garbage truck or a bus to run on natural gas is high, and the payback period might run up to seven years at todays prices. The federal government proposed o ering tax credits for eet vehicle conversion in the Natural Gas Act of 2011, which the Senate has not yet approved. We expect the trend to cleaner-burning, lowercost natural-gas-powered vehicles to continue. Infrastructure development will bring wider acceptance. In anticipation of a more comprehensive refueling network, some car manufacturers have begun to roll out vehicles that run on natural gas. The economics are better on new cars. While they cost more than their gasoline-powered counterparts, the di erence in price, about USD 5,000, is less than it would cost to retro t an older vehicle.

As we wrote in The Decade Ahead in February 2011, one of the virtues of electric cars is that they can tap into a much more diversi ed fuel mix, including natural gas, and some are even able to run on conventional gasoline. It remains to be seen if the electric vehicles will coexist with natural-gas-powered cars, or whether one will win out. In these early days, we expect car companies to continue rolling out models in both formats, as each appears to be growing in acceptance among consumers. Energy substitution: coal to natural gas US natural gas use has been growing steadily in electric power generation (see Fig. 1.14). This increased demand comes at the expense of coal, another domestic fuel source (see Fig. 1.15). The drivers of new demand for natural gas in the utility industry will be a con uence of economic and political forces.

Geopolitical instability and concerns about supply interruptions, particularly in the Middle East, have added to the price pressure and volatility in oil markets, which are likely to persist.

As prices have declined, natural gas has Looking ahead to the potential oil demand become more cost-e ective to burn than coal. impact, if 10% of the nations car and truck Because coal tends to compete with natural eet is converted to run on natural gas, we esti- gas as the marginal fuel to produce electricmate this could reduce oil consumption by one ity, run-times at coal plants have declined in million barrels per day (b/d), or 5%, based on favor of more cost-e ective natural-gas- red average 2011 US oil demand. generation.

Liqueed petroleum gases Compressed natural gas Liqueed natural gas

Electricity 85% ethanol (E85) Other

Source: Energy Information Administration, UBS

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Chapter 1

This shi , commonly called coal-to-gas switching, has hurt coal demand in the US, particularly in the Eastern US. Generally, coal- red plants in the East consume Appalachian coal, which is more expensive than other coals. Burning coal for power generation has become uneconomic versus natural gas at many plants in the Eastern US. In the Western US, power generation plants tend to burn Powder River Basin (PRB) coal, which is lower quality but less expensive and, as a result, more competitive with natural gas. Assuming xed prices (including delivery costs) of USD 83 and USD 35 a ton for Appalachian and PRB coal, respectively, we estimate that gas- red plants will continue to win market share at the expense of coal plants when gas prices are below USD 4.50 per million British thermal unit (mmbtu), whereas PRB coal- red plants can remain competitive as long as gas prices stay above USD 3.00/mmbtu. In addition to economic signals, changes to the utility fuel mix are also policy-driven. Environmental Protection Agency (EPA) rules, particularly the Mercury and Air Toxics Standards, will require coal- red power plants to install costly environmental retro ts by 2015. For some older, inef cient plants, the useful lives and run-times of the facilities will

not be long enough to recover the costs of the upgrades, which will force operators to close roughly 3% to 5% of the existing US power supply. The gap will likely be lled by natural gas plants, boosting its share of the energy mix. The EPA has also proposed new-construction performance standards, which aim to limit carbon-dioxide emissions from new fossil fuel generators. While it has not been nalized, and natural gas economics have essentially achieved it already, the rule e ectively prevents any new construction of coal- red plants. We project coal demand to decline in the US, albeit at a slower pace than we have seen in the recent past. With natural gas prices arguably having bottomed, the majority of the coal-to-gas switching has already occurred. In the future, the shi will likely be dictated by environmental mandates and occur more gradually. Worldwide, coal will remain an important energy resource for the foreseeable future, as it plays a prominent role in meeting demand for the emerging economies. Despite its environmental shortcomings, coal is abundant, a ordable and safe. Therefore, in a supply-

Source: World Bank Commodity Price Data (Pink Sheet), UBS

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constrained world, it is a necessary energy source until a viable alternative becomes available. Natural gas economics outside of North America are far less attractive, with consumers in Europe and Asia Paci c paying three to four times the North American price per unit (see Fig. 1.16). Coal demand will likely grow worldwide through the end of this decade, though growth in demand may be slower than in the past due to increased use of renewables such as wind, solar and in some regions, nuclear. Energy substitution: from fossil fuels to renewables When it comes to energy independence, the key advance for renewables will be a type of biofuel that nally succeeds in displacing crude oil used in transportation. Federal policy sets required levels of biofuel to be blended into the conventional gasoline pool. First introduced in the 2005 Energy Policy Act, the 2007 Energy Independence and Security Act introduced standards for two categories of renewable transportation fuels: one standard for the total volume of renewable fuels, and a second standard for advanced biofuels, such as cellulosic ethanol. The standard renewable fuel, ethanol, is primarily used as a blendstock in the national gasoline pool. It currently represents approximately 10% of the US gasoline pool, and is now bumping up against a blend wall, where car engines must be altered to run on gasoline with a higher ethanol component. The Environmental Protection Agency (EPA) currently allows up to 10% ethanol, which will cap growth in the use of ethanol in the gasoline pool. While the EPA has been petitioned by the ethanol industry to raise the allowable ethanol level to 15%, which was granted on a limited basis for use in newer vehicles, many retailers are unequipped to dispense the higher blend. Most automobile manufacturers warranties cover use of blends of up to 10%. For

now, we expect limited growth in the use of standard renewable fuels within transport. Researchers continue to hold out hope for a breakthrough in advanced biofuels production. These fuels would be derived from sustainable feedstocks, such as low-nutrient, highyield crops or waste from the agricultural and forestry industries. However, the technology remains immature, and advanced biofuels are not yet commercially viable. Energy efciency: policies and fuel costs support more efcient transport According to Energy Information Agency (EIA) data, US gasoline demand has declined by over 500,000 b/d from peak 2007 levels (see Fig. 1.17). Much of this decline is attributable to a higher level of unemployment, with fewer people driving to work, and other factors related to so er economic activity. However, we believe some of this demand destruction is also attributable to higher ef ciency standards and consumers growing preference for fuel economy in the face of high and volatile gasoline prices.

Weaker US energy demand growth makes North American energy independence all the more possible, while strong emerging market demand makes it all the more necessary.

Fig. 1.17: Steady decline in US gasoline demand US motor gasoline supplies, in million barrels per day10

6 1990 1995 2000 2005 2010

Source: Energy Information Administration, UBS

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Americans love big cars and light trucks. But when fuel prices are high in the US, there is typically a shi from large, gas-guzzling vehicles to more fuel-ef cient ones. Indeed, according to data published by The Wall Street Journal from market analysis website, Motor Intelligence.com, in the year-to-date through May, sales of large cars in the US are down 89%, while small and midsize car sales have risen 21% and 17%, respectively, compared to the same period in 2011. Likewise, sales of large sport utility vehicles (SUVs) have fallen by 2%, while small SUV sales are up 29%. However, it remains to be seen if these trends are permanent. Federal mandates also support more fuelef cient cars and trucks. Corporate Average Fuel Economy (CAFE) standards are a salesweighted average fuel economy, measured in miles per gallon (mpg), of the passenger cars or light trucks in a car manufacturers eet (see Fig. 1.18). Current CAFE standards require that vehicles meet an average 29.8 mpg in 2012, rising to 34.1 mpg by 2016 (formerly 2020).9 Beyond 2016, proposed standards would be increasingly stringent, rising to 38.8 mpg by 2020 and 49.6 by 2025. These rules will reduce the amount of gasoline Americans consume. In the 2012-2016 period

alone, if all vehicles on the road were subject to 2016 standards, we estimate the rules would reduce consumption by approximately one million b/d, or 5%, based on 2011 US oil demand. If the proposed rules for future years go through, the estimated reduction in oil consumption would rise to over two million b/d by 2020, or nearly 11%. All energy sources needed to meet future demand As global energy demand continues to grow, the world will face ongoing energy challenges. Planning for this eventuality is therefore critical. From a practical perspective, the only viable way to ensure a secure and sustainable energy future is to diversify away from what is now a predominantly nonrenewable, hydrocarbonbased energy supply pool.10 The US is relatively well-positioned for the near term, thanks to new supplies of oil and natural gas. However, now would be the time for the US to secure its long-term energy needs by investing in clean, a ordable and sustainable fuels. This is paramount if the US is to make a more sustainable transition to true energy security.

Note: Shaded area indicates projections. Source: International Council on Clean Transportation

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How policy can alter the energy equation

Broadly, there are two approaches that policymakers can use to alter the energy mix: Make alternatives more a ordable and accessible Discourage demand for conventional fuels We believe the most e ective energy policy is one that borrows from both approaches, but it needs to be carefully managed. It is unproductive and even detrimental to make one particular resource una ordable if there is no alternative choice, and vice versa. Policy to increase the supply of alternative fuels and technologies Market-driven change is in uenced by price, which determines demand. For policymakers, the temptation is to subsidize alternatives so that they are economically competitive with the prevailing infrastructure. Today, wind power, solar photovoltaic and electric cars are all subsidized and none are yet cost-competitive. While the intention is to wean these businesses o subsidies as technical progress is made, this is easier said than done. There is less urgency for businesses and consumers to improve processes and lower costs so long as they are pro table. Meanwhile, the government becomes stuck in a trap, as pulling subsidies prematurely would cause prices to rise, which would hurt consumers. Direct government support for research is another route, leaving it to the business community to determine how to compete in the marketplace. However, this requires a high level of commitment from the government, particularly since funding for these types of projects can o en come under pressure when there are budget cutbacks. Policy to dampen demand for conventional fuels As the adage goes, The best source of new supply is conservation. In this regard, there is a lot of low-hanging fruit in the US. One way to reduce energy demand is through programs that promote energy ef ciency and conservation, such as the CAFE standards discussed earlier. Energy-ef cient appliances and light bulbs are now mandated as well. However, it is curious, especially given that high energy costs periodically reduce household discretionary income, that forced conservation seems to be the only proven long-term e ective way to get most Americans to conserve. A far more controversial policy to lower demand is to impose taxes, fees and mandates on certain fuels. Such is the case, for instance, with the EPAs coal mandates, which require expensive upgrades to coal plants to avoid costly penalties. It was also the idea behind the recently proposed carbon dioxide capand-trade system, which did not get passed because of concerns that trading schemes can be complex, bureaucratic tools for social engineering that may also cause unintended economic hardship. For this reason, some policymakers favor a at tax. Gasoline and diesel fuel taxes are a type of at tax. Though not a popular idea, some policymakers in the US favor a higher gasoline tax to curb demand and fund alternative research. In Europe, consumers paid roughly USD 5.87 per gallon for gasoline in 2010, which included USD 3.80 in taxes, versus the average price in the US of USD 2.84/gal, which included a combined state and federal tax of an average USD 0.45.11 The US federal tax is only USD 0.184/gal and has not been increased since 1993. The implications are obvious: US drivers pay among the lowest taxes for the developed world and drive cars with low fuel economy, whereas Europeans drive smaller, more fuelef cient cars.

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Chapter 2

Energy supply: too much is never enough

Revolutionary extraction techniques will raise US oil and natural gas production at a time when the world faces structural energy supply challenges. Higher domestic oil production and greater imports from Canada can help end Americas dependence on unstable suppliers. Although America will remain dependent on fossil fuels throughout the decade, the US will continue to pursue e orts to increase the availability of renewables in the nations fuel mix.Nicole Decker, Analyst

More energy: an intense challenge For decades, Americans have taken energy for granted. This is changing as oil prices remain well above historical averages, partly re ecting sti competition for supply from developing economies. The increase in price is an unwelcome reminder that oil and gas resources are neither renewable nor recyclable. For every unit of oil and gas consumed, another unit must be found to replace it. Not only are the quantities already enormous, but the world consumes more energy year a er year. The challenges appear greatest in the oil markets. We have heard the phrase: All the easy oil has been found. It is true. Oil producers have had to extract resources from progressively dif cult-to-reach places to satisfy rising demand. This has increased the costs of extraction which are, in turn, passed on to consumers. We estimate the marginal cost of a barrel of crude has risen from USD 22 per barrel (bbl) 12 years ago to at least USD 80/ bbl today (see Fig. 2.1).

Energy pursuits: access, technology and knowhow The energy industry has steadily evolved through innovation and ingenuity. Technical improvements have enhanced environmental protection, and production has grown more ef cient to optimize available reserves. The 2010 BP disaster was a sober reminder of the risks and dangers of oil and gas exploration. However, in the early 1900s, oil gushers, such as the famous Spindletop well in Texas, were routine. They coated the countryside with mil-

June 2012 UBS research focus

Energy supply: too much is never enough

lions of barrels of oil, wasting natural resources and causing long-lasting environmental damage. The invention of the blowout preventer in the 1920s was an important technical development for the industry and remains so today. Oil exploration now entails sophisticated subsurface imaging, elaborate calculations and highly specialized equipment that help uncover resources in increasingly remote and precarious places. Still, the worlds proved oil reserves represent less than 50 years of supply, based on current oil demand levels. Whats more, oil reserves in most of the Organization of the Petroleum Exporting Countries (OPEC), as well as some other large non-OPEC suppliers are o limits to international exploration and production companies. Approximately 70%-80% of current world reserves are controlled by national oil companies or sovereign-owned companies (see Fig. 2.2). As a result, a large portion of the worlds oil supply is tightly controlled by countries whose interests are not necessarily aligned with that of energy consumers. OPEC: supply constraints OPEC was formed in 1960 to provide a large,

uni ed voice on oil industry issues. As the US became a net importer of crude oil in the early 1970s, OPEC had gained a dominant position in world oil markets and an ability to in uence oil prices (see Fig. 2.3). Sometimes it exercised its in uence in ways that undermined global growth. For example, in October 1973, OPEC initiated an embargo (to protest US and other Western nations support of Israel during the Yom Kippur War). In a matter of weeks, world oil prices tripled. In 1979, the Iranian Revolution ravaged many of Irans producing elds. Until 2008, this was the highest level ever for oil prices in real terms. Since that time, the US has sought to reduce its dependence on OPEC oil supplies. OPEC has moved away from the role of a cartel to that of the worlds swing producer. The organizations self-appointed task is to alter production through a quota system to balance world oil supply and demand (see Fig. 2.4). However, the aw in OPECs stated mission is that it con icts with an economic motivation to optimize the revenues generated by its resources. Most OPEC nations have little industry other than oil, and are dependent upon oil revenues

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to fund social and government programs. As a result, most OPEC nations and other sovereign-run oil companies tend to underinvest in their own oil industries to preserve their resources investing only enough to support production that will satisfy internal government funding needs. Failure to maintain a comfortable cushion in spare capacity has caused the market to lose con dence that OPEC is able to raise production to meet rising global demand. This concern is exacerbated when civil unrest, such as the uprisings in Libya and Nigeria, and potential military action, such as in Iran, threaten to remove millions of barrels of production and capacity from world markets. With spare capacity already depleted at 3.1 million barrels per day, a major event would nearly wipe out OPECs spare production capacity. Beyond OPEC: another technological leap under way Even the best oil elds can only produce for so long. Many of the world-scale basins that have served for decades, such as the North Sea, are mature, and production is now tapering o (see Fig. 2.5). With limited access to new resources because of nationalization, operators are turning to frontier regions

where oil and gas have not been previously explored for or produced. These hard-to-reach places include Arctic regions, deep below salt layers (subsalt) and o shore in ultra-deepwater. Just as in the past, we believe this next generation of exploration could be crucial to future world supplies. The dif culty and high cost of extracting this oil will likely keep global oil prices elevated, and this oil will only be exploited if prices are high. Oil: ending OPEC imports Given all the constraints on global oil production, we think Americas shale oil and gas revolution is truly a game-changing development. In particular, we think the development of this energy resource will free the US from reliance on OPEC crude oil by 2020 and enable the nation to become a net exporter of natural gas even sooner. While the decline in oil consumption discussed in Chapter 1 provides the US with some additional energy security, there are two supply-related trends that will likely contribute to independence from OPEC: Rising US oil and natural gas production Increased oil imports from Canada Imports of 8.9 million b/d accounted for 59% of the total crude that the US input into its re neries in 2011. Of this, Canada and Mexico

Given all the constraints on global oil production, we think Americas shale oil and gas revolution is truly a game-changing development.

Brent crude oil price

June 2012 UBS research focus

Energy supply: too much is never enough

supplied 3.3 million b/d (see Fig. 2.6).1 OPEC supplied 75% of the crude oil from outside of North America. Among the OPEC nations, the US imports the most from Saudi Arabia, Venezuela and Nigeria. However, supplies from all three of these countries have been threatened by civil unrest and other geopolitical issues, highlighting the instability of the US oil supply base. US oil production. By the end of this decade, the Energy Information Administration projects domestic oil production to rise to 6.7 million b/d, up 22% from 2010 levels. However, the EIAs oil production estimates are conservative, in our view. Already, only a few months a er the projections were published, US oil production is over 6 million b/d, above the EIAs projections for 2012 (see Fig. 2.7). Production has risen by over 600,000 b/d in the last year. We believe that US oil production could rise by at least another 2 million b/d to over 8 million b/d by 2020. Onshore shale oil accounts for most of the recent sharp increase in US oil production. We estimate that production in the Eagle Ford and in the Bakken alone has risen by over 700,000 b/d in the past three years. We believe shale production in the US is only in the early stages

as exploration continues in other plays, including the Permian Basin in Texas, the Monterrey shale in California and the Denver-Julesburg Basin in Colorado. We believe the Gulf of Mexico has been overlooked as activity was halted by the drilling moratorium following the tragic Macondo accident in 2010. Oil production in the Gulf of Mexico declined by 15% (234,000 b/d) in 2011. The moratorium has been li ed, as regulators and operators have stepped up standards to help ensure safer operations. The permitting process has resumed, and exploration and development activity is expected to reach pre-incident levels by the end of 2012. Production has turned upward in 2012 to date (see Fig. 2.8). With subsalt exploration in the Gulf of Mexico only beginning, new supplies from the Gulf of Mexico could surprise to the upside, in our view. Oil imports from Canada. Canada is already the single-largest source of imported oil for the US, and over 97% of Canadas exports ow to the US (see Fig. 2.6), accounting for nearly one-quarter of total US imports. Canada has large deposits of heavy crude oil that are now economically recoverable, thanks to new technologies. According to the BP Statistical

Fig. 2.6: Canada is the largest source of US imports Crude oil imports to the US by country as a share of total imports, in %, 201125 20 15 10 5 0 Saudi Arabia Angola Kuwait Mexico Colombia Canada Nigeria Venezuela Ecuador Algeria Iraq Russia Brazil

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Chapter 2

Review of World Energy 2011, Canadas combined conventional oil and oil sands reserves top 175 billion barrels, which places it squarely in the top ve in the world (see Fig. 2.9). The Canadian Association of Petroleum Producers 2011 report forecasts oil production in Canada will rise to 4.2 million b/d by 2020, from 2.8 million b/d in 2010.2 There has been some question as to whether new supplies from Canada will be sold to the US. Controversy centers around the environmental e ects of oil sands production, processing and re ning. In addition, of cials have delayed construction of the proposed Keystone XL pipeline, an infrastructure project that would transport additional Canadian crude oil to the US. The project is held up in a lengthy permitting process on concerns about the spill risks near drinking water supplies and other environmentally sensitive areas. Absent US support, some Canadian producers have begun to look at export markets accessible from the Canadian West Coast, though pipelines over the Canadian Rockies could be dif cult. However, there are a number of smaller pipeline projects that could connect to preexisting cross-border infrastructure, which would boost capacity to transport oil to the US and not require fed-

eral approval. This would be a lower pro le way to bring incremental crude production from Canada to the US. New oil supplies from the US and Canada clear the path to energy independence in North America. OPEC oil exports to the US could fall to zero by 2020 (see Fig. 2.10). There are challenges, we know; additional hurdles will arise. But much has already been accomplished, and only a continuation of the momentum that has already begun is needed to achieve independence.3 Natural gas: supply outpaces domestic demand Hydraullic fracturing and horizontal drilling technology (commonly called fracking) has resulted in such rapid growth in natural gas production that the US is experiencing a supply glut, forcing natural gas prices to low levels. (See appendix on page 31 for a more complete discussion of shale oil and gas techniques and environmental considerations.) Shale gas production in the US grew at an annualized rate of 32% between 2000 and 2010 (see Fig. 2.11). Most of the recent growth comes from the newest and largest of the US shale gas plays: the Marcellus in the US Appalachian Basin.

Source: Energy Information Administration, UBS

June 2012 UBS research focus

Energy supply: too much is never enough

In the early days of petroleum exploration, natural gas was not considered a useful product and was burned o . While the US has historically been self-suf cient in natural gas, production had been in a gradual decline since the mid-1970s, as elds in the Gulf of Mexico matured. As a result, several terminals were constructed on the US coasts to receive imports of lique ed natural gas (LNG) (see box on page 22). These terminals now essentially sit idle, and some are in various stages of permitting for conversion to LNG export terminals. By the EIAs projections, the US will be a net exporter of LNG by 2016. The EIA estimates technically recoverable shale gas reserves in the US at 482 trillion cubic feet (tcf). Total gas reserves in the US would support current demand for 100 years. US natural gas production is projected by the EIA to rise to 25.8 quadrillion Btu by 2020, up 17% from 2010 (see Fig. 2.11). More likely, natural gas production growth will be dictated by demand growth and exports for the foreseeable future. As vast supplies lie in wait, the industry could accommodate a signi cant increase in demand. Importantly, we believe supplies are adequate to hold prices well below those seen in LNG-dependent markets elsewhere.

Coal: marginalized but not going away The US holds estimated coal reserves that would last upwards of 200 years, based on current demand levels. Coal represents approximately 20% of the energy consumed in the US, the third-largest energy resource behind oil and natural gas. Most of the coal consumed in the US is used to generate electricity. As power-generation economics move in favor of cleaner (at least to burn) and cheaper natural gas, coal producers are turning to export markets. The future of coal in the US goes beyond a ordability and supply. With new competition from natural gas, the case for coal is a ordability of clean supply. A major research e ort is under way to develop clean coal technology, but thus far, the feasibility of clean coal technologies remains unproven. Given its prevalent market share of the US energy resource base, it will not be possible to eliminate the use of coal any time soon. However, using less of it marks an important step toward a cleaner energy base. Seeking long-term solutions A more secure supply of oil and natural gas is exciting and bene cial for the US. And

2030 Shale gas

Non-associated onshore Associated with oil Coalbed methane

Alaska Non-associated oshore Tight gas

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Chapter 2

although fossil fuels will likely still comprise over three-quarters of the total US energy resource base by the end of the decade not much less than its current share there will be important shi s in the fuel mix toward natural gas and away from oil and coal. The US will remain reliant upon hydrocarbonbased energy until a ordable and practical renewable alternatives are developed. Shale supplies have granted some time, but without suitable renewable alternatives, breaking the fossil fuel habit will be next to impossible. One non-fossil-fuel-based energy resource that is viable but unpopular today is nuclear. Nuclear power is used to generate approximately 20% of the electricity in the US, whereas in France it provides closer to 75%. The administration, once pro-nuclear, has grown more ambivalent in the wake of the Fukushima meltdown. However, permits for construction of four new reactors were issued earlier this year, the rst approvals since the partial meltdown at Three Mile Island in Pennsylvania in 1979. But most utilities have curbed nuclear plans, due to increased competition from low natural gas prices, lack of funding or lackluster demand. What about other energy alternatives: solar, wind, tidal, geothermal, biomass and biofuels? All have their place and all can contribute, but costs still need to come down. We expect that the energy resource base of the future will comprise a wide variety of renewable energies and technologies. Most likely, the US energy sup-

What is LNG?Lique ed natural gas (LNG) is an innovation that allows natural gas to be more easily transported long distances by freezing it into a liquid state. A relatively expensive process, LNG has become a prevalent source of supply to markets outside of the US, helping to explain why natural gas prices are so much higher internationally than they are in the US.

ply base will be in an eternal state of evolution. We say this for three reasons: 1) there is always a better, more ef cient way to use energy; 2) there will always be a need to increase supply to accommodate the worlds energy needs; and 3) we will always nd ways to harness new sources of energy. As we look at the US, we see that the evolution has begun. The work must go on, so that when the time comes, the supply will be available.

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Chapter 3

Americas energy opportunity

North Americas oil and natural gas revolution represents a boon to the US economy and underscores our view that America will undergo a manufacturing renaissance this decade. Oil and gas development has employment and investment bene ts, the extraction technology and fuels have export potential, and companies and consumers have access to relatively low-cost energy. Importantly, market forces not energy policy are creating these opportunities.Kurt Reiman, Head, Thematic Research Wealth Management Research; Nicole Decker; Joseph Kenol; George Lambertson; David Le owitz, CFA; Andrew Sutphin; Jon Woloshin, CFA, Analysts

Energy as a game changer The development of domestic oil and gas reserves holds promise for the US economy at a time when structural deleveraging headwinds are tempering enthusiasm about the long-term economic outlook. As we wrote in the June 2011 edition of the UBS research focus entitled, US competitiveness: Americas still got talent, the nation has achieved some of the strongest productivity gains among developed countries in recent decades.1 Despite its relatively large pool of domestic demand and low levels of

international trade, the US economy consistently generates outsized gains in productivity. Because of these productivity gains, US labor compensation has risen by less than many of its emerging market and advanced economy peers (see Fig. 3.1). Increased availability of comparatively cheap natural gas creates an additional competitive advantage for the US economy. Secure and abundant supplies of energy (not to mention another important resource, sustainable supplies of fresh water) favor the return of manufacturing, industrial and petrochemi-

Japan South Korea

Note: Each decade reects the average of unit labor costs over the period. Source: Bureau of Labor Statistics

Source: Bureau of Labor Statistics, UBS WMR

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Chapter 3

cal activities to the US a er a decades-long exodus (see Fig. 3.2) since these industries are big energy consumers and would accrue enormous cost savings. Moreover, the extraction technology is exportable to overseas markets, as are the fuels. A June 2012 Q-Series report from UBS Investment Research concludes that a sustained relative energy price advantage in the US could boost intermediate-term US real GDP growth by around 0.5% per annum.2 According to UBSs chief US economist, Maury Harris, The relative decline in natural gas prices on balance, over the past few years have been dramatic enough to become a key element in the argument for a US manufacturing renaissance in the next half decade and beyond. Moreover, if there were no o setting stronger dollar e ects, the net e ect would be around 0.8% per annum. Although this additional growth might not sound like a lot, if it were sustained over 25 years it would add another USD 5.3 trillion or 40% of 2011 GDP to US economic output relative to a base case of an average 2.5% growth rate over the decade. Given the comparative advantage a orded by vast US natural gas reserves and the potential for future exports, development of domestic

energy sources rather than imports is an important potential antidote to ongoing debt deleveraging and a sluggish US economy. At a time when many economic sectors are either limping along or are in the midst of an outright decline, employment and investment in natural resource industries, though small, could prove bene cial to income formation (see Figs. 3.3 and 3.4). Moreover, indirect employment gains through associated industries, such as in petrochemicals, materials, utilities and autos, could be a multiple of the direct employment bene ts. Americas relatively lower energy costs could mean more income and pro ts to reinvest in research and development, perhaps even in renewable fuels, which could boost longterm productivity growth and generate new technology to propel the next wave of abovetrend economic growth. In addition to securing natural resources, the country will need to continue investing in ef ciency upgrades and the best available energy technology. A er all, advances in productivity and innovation matter greatly to economic growth over the long term. In a similar vein, the US will need to develop untapped resources in a way that does as little harm to the greater environment as is possible.

Fixed investment in mining activities as a share of US GDP (lhs) Oil and gas extraction value added as a share of US GDP (lhs) Oil and gas extraction employment as a share of total US employment (rhs) Source: Bureau of Economic Analysis, Bureau of Labor Statistics, UBS

Source: Federal Reserve, UBS

24

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Americas energy opportunity

The risks of a resource boom

Natural resource discoveries are not without potential pitfalls. For example, the export demand and investment ows that stem from nding large, previously unrecoverable oil and natural gas deposits could cause currencies to appreciate, which then disadvantages the wider non-energy tradables sector of the economy. Economists refer to this as Dutch disease,3 the phenomenon in which countries experience a boom in natural resources, make them available as exports and then watch their domestic manufacturing industries decline under a stronger currency. In our view, the prospects of Dutch disease infecting the US are unlikely since the economy is so highly diversi ed and because exports comprise such a small share of GDP. Abundance of domestic energy presents another risk to long-term US economic growth since cheap fuel could undermine e orts to improve energy ef ciency and clean-tech innovation. As it stands now, the US already consumes more energy per unit of GDP and per person than many developed countries (see Fig. 3.5). The US also has a low share of renewable fuels in the overall energy mix (see Fig. 3.6). Per capita energy use is relatively high in part because of wide annual temperature variation and low population densities in North America.4 However, historically low gasoline taxes and a prolonged period of cheap energy also encouraged wasteful behavior, such as a preference for big and inef cient homes and cars. If energy policy does not continue to reinforce existing market-driven incentives to upgrade energy ef ciency and make advances in renewables technology, access to inexpensive natural gas could do more harm than good.

Source: BP Statistical Review of World Energy 2011, UBS

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Chapter 3

A wide range of industry benets In addition to the boost to the overall US economy, companies and industry sectors also stand to bene t from the e orts and incentives to make greater use of North American energy supplies. Energy companies will make considerable investment in developing new resource plays, as well as much-needed infrastructure build-outs and upgrades (see Fig. 3.7). Moreover, the high price of oil both in absolute terms and relative to natural gas will likely encourage boosts to energy ef ciency and new alternative modes of transportation. What follows is a discussion of how North American energy independence a ects speci c industry sectors. We provide a separate report that features our views on speci c investment recommendations tied to this theme. Energy Oil and gas. We have a positive outlook on the oil and gas sector and recommend selective exposure to high-quality operators in North America. For natural gas producers, near-term recovery in natural gas prices at least to breakeven levels would provide support. Over time, true value creation will come through superior execution, since we do not expect prices to rise much beyond the mar-

ginal cost for the next several years. Natural gas production in the US is unlikely to grow as fast as it has in recent years, especially given demand constraints, but Marcellus shale operators are advantaged by the plays lower costs. For oil producers, well-executed growth could be a key di erentiator. (See our report dated 18 April 2012 entitled US Oil and Gas Shale Guide for a list of companies exposed to this theme). In the North American oil and gas services sub-sector, there are concerns that the upturn may have peaked. However, we believe that industry leaders will continue to bene t over the long term from robust activity and margin-enhancing improvements in operating ef ciency. Coal. The long-term outlook for US coal is mixed, and we are cautious on the industry for now. If natural gas supplies remain abundant as we believe they will, we expect US coal demand to gradually decline as environmental rules that make the use of coal more dif cult take e ect. However, demand for coal is robust outside of the US, driven by steel production in the developing economies, such as China. Many US producers, as a consequence, have turned to the export markets. Producers in the

The development of domestic oil and gas reserves holds promise for the US economy at a time when structural deleveraging headwinds are tempering enthusiasm about the longterm economic outlook.

June 2012 UBS research focus

Americas energy opportunity

Appalachia region in particular have bene ted from their access to export markets. Additional export facilities are planned for the East and West Coasts, as well as the Gulf Coast. Master limited partnerships (MLPs). Notwithstanding the recent strong performance, we believe the long-term fundamental outlook remains favorable for MLPs (see Fig. 3.8). (MLPs are primarily engaged in the gathering, processing, transportation and storage components of the energy business in other words, the midstream part of the energy value chain.) US oil and gas production continues to rise, perpetuating the need for more gathering pipes and processing facilities. Furthermore, the North American shale oil and gas boom has created a need for signi cant additional infrastructure (pipelines, compression equipment, etc.) given that many of the plays are in regions not traditionally associated with energy exploration and production. Examples include the Eagle Ford in South Texas, the Bakken in North Dakota and the Marcellus in northern West Virginia/southern Pennsylvania. As a result, these unconventional plays are driving a build-up of midstream infrastructure to connect upstream shale producers to downstream end users.

Power generation The emergence of natural gas as a plentiful energy resource will likely have a signi cant impact on power generation. As an inexpensive, cleaner alternative to coal, natural gas has become an economically and politically attractive fuel choice for electricity production, especially for new power plants. While the prospects for natural gas are bright, investors should bear in mind that coal will likely remain the most widely used fuel in power generation in the US for at least the next decade, and likely longer. As a plentiful, inexpensive and cleaner alternative to coal, natural gas will continue to take share as one of the primary fuels used in the production of electricity. In spite of the consequent negative impact on power prices, natural-gas- red merchant plants will bene t as declining prices are o set by higher utilization. Because natural-gas- red plants tend to be the marginal producers of electricity, natural gas and power prices are highly correlated (see Fig. 3.9). This has had signi cant negative consequences for companies that own deregulated generation, which are exposed to commodity price uctuations. Utilities that derive a large portion of their earnings from unregulated

Natural gas price, in US dollars

Power price (lhs) Natural gas price (rhs) Source: Bloomberg, UBS

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Chapter 3

nuclear and coal operations will likely continue to face a challenging environment as a result. Transportation Autos. We believe that Highly Ef cient Powertrains (HEP) for gasoline-powered cars and light trucks will be the strongest driver of improved vehicle fuel ef ciency in the US through 2020. We think automakers that deploy these technologies and auto suppliers that manufacture them will be the biggest bene ciaries of this trend. The auto and auto-parts supplier industries have been incredibly successful in obtaining public acceptance of smaller vehicles and more fuel-ef cient combustion powertrains. Over the last several years there has been a steady shi toward smaller and lighter vehicles and toward cars and light trucks with downsized engines, turbochargers and gasoline direct-injection technology. The National Highway Traf c Safety Administration notes that average car fuel ef ciency increased from 31.5 mpg in 2008 to 35.6 mpg in June 2012. We expect traditional hybrids, plug-in hybrids and electric vehicles to take signi cant share toward the end of the decade as global production scale grows, battery costs come down, range increases and charging infrastructure broadens in metropolitan areas. Compressed natural gas (CNG) has strong potential to gain share in the market for heavy trucks and buses where it already has acceptance. Given that CNG fuels only 2%-3% of the medium- and heavy-truck segment, there should be good potential for growth coming o a low base. That said, we think there is limited potential for success in the larger market for light vehicles due to range anxiety, a large fuel tank that reduces vehicle utility and the high cost of needed fueling station infrastructure. Rails. We believe there are a number of secular growth drivers supporting the rail sector that more than o set the long-term decline of util28 June 2012 UBS research focus

ity coal shipments. We do not wish to diminish the importance of coal to the rail industry. However, it is important to understand that domestic utility coal shipments currently represent, at most, 10% of industry volume shipments (varying by railroad). In addition, export coal, which is generally more pro table than domestic utility coal, has supplanted a signi cant portion of coal volumes. Furthermore, the shale oil and gas expansion around the US has created substantial new growth markets for the rails, which includes fracking sand, steel, chemicals and petroleum shipments. These shipments should provide signi cant future revenue growth opportunities. Trucks. The lack of CNG lling stations and only a measured rate of development over the next several decades suggests that, outside of large shipping and hauling eets, the trucking industry will likely be slow to migrate to the technology. As such, assuming an environment of elevated diesel fuel prices and more stringent environmental regulations, the trucking industry is likely to be at a competitive disadvantage relative to the rail industry for declining lengths of haul. Chemicals and materials The widespread availability of natural gas in particular, the dramatic growth in shale production is heralding a nascent materials renaissance in the US. According to the EIA, the US chemical industry has historically been one of the largest consumers of natural gas, comprising nearly 30% of total manufacturing demand in 2009 (see Fig. 3.10). The impact of cheaper and more plentiful natural gas for the domestic chemical industry is enormous, in particular because it packs a double wallop: not only is it a cost-e ective fuel in an energyintensive industry, but it is also a cost-advantaged raw material over higher cost oil-based derivatives used as a raw material for domestic commodity chemical producers.

Secure and abundant supplies of energy favor the return of manufacturing, industrial and petrochemical activities to the US after a decades-long exodus.

Americas energy opportunity

Natural gas can be fractionated into lowcost feedstocks like ethane or propane used to make a host of building block ethylenebased commodity chemicals or as feedstock for hydrogen and syngas production each used to produce another set of building block chemicals, like methanol, acetic acid and other chemical derivatives. In turn, these cost-advantaged downstream chemicals further comprise the building blocks for industries like glass, paper and plastic. The natural gas boom greatly reduces the production costs for domestically produced ethane, and its greater availability pushes the US petrochemical industry down the global cost curve, giving it a competitive advantage over global commodity chemical companies using naphtha a now more expensive, oil-derived feedstock. A domino e ect of sorts is set o as lower gas prices not only reduce costs for the chemical industry but also associated industries, like steel and auto-making. Energy infrastructure Engineering and construction rms are seeing higher demand from the oil and gas industry for natural gas infrastructure build-out especially the construction of plants and transportation facilities. The environmental solutions business, such as fracking wastewater management, represents another potential opportunity but it is a highly fragmented sector and generally handled by private local companies. However, a few are working on a larger scale. Infrastructure demands are quite high in order to make CNG suitable as a transportation fuel and LNG viable for export. We would focus on companies that specialize in building naturalgas lling stations, converting conventional vehicles to natural gas power and building LNG export terminals.

Americas energy opportunity The trend toward North American energy independence is perhaps most directly linked to energy exploration and production, oil and gas services and the build-out of energy infrastructure. However, the theme has other farreaching economic and sector implications. Relatively inexpensive natural gas creates a competitive advantage for the US. As a result, we expect the US economy will experience a manufacturing renaissance through the repatriation, relocation and expansion of energyintensive industrial operations. This trend is especially powerful for the petrochemical and materials sectors. The comparatively high price of oil will likely prompt drivers to switch to more fuel-ef cient vehicles and alternative powertrains, such as hybrids and electric vehicles. Power generation will increasingly rely on natural gas instead of coal, and natural gas will also nd its way into the transportation fuel mix through use of compressed natural gas and other natural gas technologies in eet vehicles, as well as through the wall outlet for plug-in electric cars.

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ConclusionOn several occasions over the past few decades, US of cials have fretted about the adequacy of the countrys energy supply base, usually in response to a spike in oil prices. Then, Americans urgently resolved to reduce their dependence on unreliable sources of energy. But the solutions temporary xes at best have fallen short. Most o en, a decline in demand would yield lower prices, and life would return to normal. The long-term challenge of securing a reliable and a ordable energy future remains unaddressed. However, we believe the US has nally embarked on a path to improve its energy supply security. Thanks to advances in drilling technology, oil and gas production in the US is rising. Production in Canada, the largest and most reliable source of imported oil for the US, is also rising. These supplies should reduce the need for waterborne imports of oil to the US. Equally important, demand for re ned oil products in the US has been trending lower since 2007, re ecting reduced consumption due to conservation and ef ciency, and diversication away from oil products to other fuel sources. Natural gas, the cleanestburning fossil, has become abundant in the US, making it an a ordable and environmentally attractive alternative to coal and oil. Indeed, the US has started down a path, taking the rst promising steps toward zero reliance on imported oil from the Middle East and to an energy-independent North America. Along this path to greater energy security, America is beginning to build a bridge to a diversi ed and more sustainable energy resource base, away from fossil fuels and toward renewable alternatives, which is paramount to a secure energy future. It will take some time and planning to wean the US o fossil fuels, though, given the countrys current heavy reliance. New oil and gas resources will give America independence from unstable oil suppliers, and it will buy some time to prepare for the use of substitute fuels. However, true energy independence means that consumers would no longer be held hostage to both the suppliers and the supplies. As America achieves self-suf ciency, it must also take the next step on the path to complete independence, which is to build and eventually cross the bridge to renewable fuels.

30 June 2012 UBS research focus 30 June 2012 UBS research focus

Appendix

North American shale oil and gas: the basics

Nicole Decker, Analyst

There is no question that shale oil and gas production is a technological marvel. In the US, shale production began over 10 years ago in a natural gas play called the Barnett in central Texas (see Fig. A1). As the techniques were applied to other shale gas plays, the US saw a sharp ramp-up in natural gas production. In shale oil, the same new drilling techniques were rst applied in the Bakken shale, located in the Williston Basin in North Dakota in the second half of the last decade. Most of the US onshore oil production growth in the past four years has come from this region. However, other shale oil plays, particularly the Eagle Ford, are now contributing to the growth. Many more are being tested. Exploration and production of shale oil and gas resources is not only costly, but challenging from an environmental perspective. Much progress has been made, but there is room for improvement. The primary objective of the US oil and gas industry is to safely and ef ciently extract oil and gas from shale resources in an environmentally conscientious manner. Efcient extraction. Horizontal drilling and hydraulic fracturing (commonly called fracking) are now widely used in the shale plays. How does it work? In the past, wells were drilled vertically into a target zone. This sufces when the oil or gas in the zone can ow, as operators have a variety of techniques to coax the resource to ow to the wellbore. In shale plays, the oil and gas is trapped inside shale rock. It does not ow, so only a small amount of oil and gas can be produced with a vertical well. If you think of the earths subsurface geology like a multilayer cake, imagine that one

of those layers is shale rock with oil and gas embedded in it. To increase the physical contact of the wellbore with the shale rock, the industry developed directional drilling, or in this case, horizontal drilling (see Fig. 3.10). Still, only a limited amount of oil and gas comes in direct contact with the wellbore, and it will not produce enough to justify the cost of the technically complex horizontal well.1 Fracking solves the problem by increasing the exposure of the wellbore to the shale rock. Once the horizontal portion of the well is drilled, the rock surrounding the wellbore is fractured, so that the oil and gas trapped in the rock can escape through the cracks. The rock is fractured by pumping a mix of sand, water and chemicals into the well at very high pressure (pressure pumping). These wells can be highly productive. In general around the US, shale operators can cover their costs and earn an acceptable return when prices are above USD 75-80 per barrel for oil and USD 4-5 per million British thermal unit (mmbtu) for natural gas. The industry continues to work to improve the process to further increase productivity and reduce the high cost of extraction. Environmentally responsible operations. Public debate over the environmental e ects of fracking has been focused on three primary issues. First, some of the chemicals that have been used in the fracking process are toxic, and drilling occurs near sources of drinking water supplies. Fracking uid has turned up in drinking water supplies in a few locations around the US. State of cials now monitor and regulate the chemicals that may be used in the frackingNorth American energy independence: reenergized June 2012 31

Marcellus Devonian Utica

Haynesville Barnett Eagle Ford Tuscaloosa

Eagle Ford, La Casita

Current shale plays

Source: International Energy Agency

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Appendix

process. Many operators have moved to a mix of organic-based, non-toxic fracking uids. It remains unclear as to whether contamination occurred in the fracking process. Numerous studies have been conducted without turning up conclusive evidence that uid can migrate through several layers of rock to the water table. Another possible explanation is that fracturing uids were mismanaged on the surface. Just before a well begins production, the used fracturing uid is cycled back up the well and is either stored on the surface for reuse or disposed of in deep underground wells. Today, strict regulations have tightened standards for water management and disposal under the Clean Water Act and by the Safe Drinking Water Act.

The second concern is about water usage. Each well drilled requires 2 to as many as 10 million gallons of fresh water far more than traditional vertical wells. As shale drilling occurs in many of the countrys agricultural centers, local water supplies are stretched. Water demands for fracking are at odds with the needs of the farmers. The problem will escalate as activity rises. Improvements have been made. Some of the water is now recycled for use in several wells, reducing average per-well water usage at some sites. Techniques to reduce or eliminate water usage are also being tested. Third, natural gas recovered during shale oil production is sometimes ared, releasing

Fig. A2: Horizontal drilling and hydraulic fracturing

Water table

1000s of meters

Impermeable seal layers

Shale

High pressure fracturing uid rst cracks the shale

Fine particles (proppant) keep the fractures open

Shale oil/gas ows into the pipe and up the well

Source: International Energy Agency

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greenhouse gas into the atmosphere. Normally, a small amount of natural gas, called associated gas, is produced from an oil well. This gas is separated, processed and transported through pipelines to be sold into the market. In certain shale oil plays, such as the Bakken in North Dakota, infrastructure to process associated gas is lacking. The amount of gas produced is relatively small, but rising oil production will make the cumulative amount of ared gas more signi cant. The problem can be solved over time as more gas plants are built. Safety. Oil and gas drilling is hazardous, but the risks rise when done in populated areas. Blowouts are rare, but they can occur. In addition, drilling operations require outsized equipment and a large amount of supplies, much of which is brought in by trucks. In some regions, such as the Bakken and Eagle Ford, some of the oil is transported by truck. All this activity eats up roads, and increases the risk of accidents. As pipelines are completed, the oil truck traf c will diminish. But movement of equipment is part of the process. The industry must maintain high standards for the people they hire to ensure safe and responsible handling of equipment. Attempts are also being made to link fracking activity to an increase in the occurrence of tremors and small earthquakes around the US. Most recently, two earthquakes measuring approximately 4.0 on the Richter scale occurred near a fracking site in Ohio. They are thought to be the result of wastewater disposal. This is being carefully monitored, but will undoubtedly be an area of public concern as more disposal wells are drilled.

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Reengergized

GlossaryBrief de nitions of terms used in this report

Barrel (bbl): A measure of oil quantities; equals 42 gallons Biomass: Fuel that is derived from organic materials such as plants, wood, or agricultural waste. British thermal unit (Btu): The amount of heat needed to raise the temperature of 1 pound of water by 1 degree Fahrenheit at the temperature at which water has its greatest density (approximately 39 degrees Fahrenheit). CAFE: Corporate Average Fuel Economy regulations in the US, designed to improve average fuel ef ciency of cars and light trucks. Carbon dioxide (CO2): A colorless, odorless gas that is naturally present in the Earths atmosphere. It is formed when fuel containing carbon is burned. It is considered a greenhouse gas as it traps heat radiated by the Earth into the atmosphere. Coal bed methane (CBM): A type of natural gas that is extracted from coal beds. Compressed natural gas (CNG): Natural gas under pressure (about 3,100 pounds per square inch) that is used as a fuel for natural-gas-powered vehicles. Electric vehicle: A vehicle that is powered by an electric motor rather than a gasoline engine. The electric motor is powered by rechargeable batteries, fuel cells, solar arrays, or another electric source. Emissions: Releases of gases into the Earths atmosphere. Energy Information Administration (EIA): An independent agency within the U.S. Department of Energy that develops surveys, collects energy data, and does analytical and modeling analyses of energy issues. The Agency must satisfy the requests of Congress, other elements within the Department of Energy, Federal Energy Regulatory Commission, and the Executive Branch, its own independent needs, and assist the general public, or other interest groups, without taking a policy position. Ethanol: A clear, colorless, ammable alcohol that is used primarily as an additive to gasoline. It is

made from plants that contain sugar or starches that can be converted into sugar such as sugar cane and corn. Flexible fuel vehicle: A vehicle that can alternate between an alternative fuel such as ethanol and a petroleum-based fuel. Greenhouse gases: Gases such as water vapor, carbon dioxide, methane, nitrous oxide, and ozone, which absorb infrared radiation and warm the planets surface. Gross domestic product (GDP): The market value of goods and services produced by labor and property within a country. Flare: A process used for the combustion and disposal of ammable gases at facilities such as re neries and chemical plants. Natural gas is also ared when a method for transporting gas to markets is lacking. Fossil fuel: A nonrenewable energy source formed over millions of years from decayed organic material. The common fossil fuels are petroleum, coal, and natural gas. Horizontal drilling: The drilling of an oil or gas well, rst vertically, then turned roughly 90 degrees so that it runs parallel in the formation containing the oil or gas. Hydraulic fracturing: Fracturing of rock with pressurized uids. In tight sands and shales, it is used as a method of stimulating oil or gas production. Hydrocarbon: An organic compound consisting of hydrogen and carbon in a gaseous, liquid, or solid state. International Energy Agency (IEA): An intergovernmental organization which works to ensure reliable, a ordable, and clean energy for its 28 member countries and beyond. It was originally established within the Organisation for Economic Co-operation and Development (OECD) in 1974 to respond to disruptions in oil supplies, and to serve as an information source on the international oil markets. Liqueed natural gas (LNG): Natural gas that has been lique ed by cooling its temperature toNorth American energy independence: reenergized June 2012 35

approximately -260 degrees Fahrenheit so that it can be transported. LNG takes up 1/600th of the space of the same amount of natural gas in a gaseous state. Marginal cost: The cost of an additional unit of output. MMBtu: One million British thermal units (see British thermal unit) Nonrenewable fuels: A natural resource that cannot be reproduced, or is consumed at a faster rate than nature can create it. Nuclear power: Electricity generated by the use of the thermal energy released from the nuclear ssion or fusion in a reactor. OPEC (Organization of the Petroleum Exporting Countries): An intergovernmental organization of twelve oil-producing nations whose stated objective is to coordinate and unify the petroleum policies of member countries. Member countries oil production levels are determined through a collaborative process. Primary energy: Energy that is in a form that has not undergone any transformation or processing. Examples of primary energy are coal, crude oil, sunlight, wind, and natural gas. Powertrain: In a motor vehicle, this is the hardware assembly by which power is transmitted from an engine to a driving axle. Quadrillion: 1,000,000,000,000,000 Real dollars: Dollars adjusted for in ation.36 June 2012 UBS research focus 36 UBS research focus

Rened petroleum products: Fuels produced from crude oil, including gasoline, diesel fuel, heating oil, jet fuel, and residual fuels. Renewable energy resources: Energy resources that are naturally replenished such as biomass, hydro, geothermal, solar, wind, ocean thermal, wave action, and tidal action. Retrot: To install a device or system into existing equipment for modernization purposes. Shale oil or gas: Oil or natural gas that is produced from shale formations. Shale is a sedimentary rock primarily of silt and clay. Solar energy: Energy harnessed from the radiant light and heat from the sun. Ton of oil equivalent: The amount of energy released by burning one ton (7.4 barrels) of crude oil. Unconventional: A general term referring to oil and gas production techniques or fuel uses that have not been widely used in the past. Watt (W): A standard unit of electrical power equal to one joule per second. A Watt is equal to 1/746 horsepower. Wind energy: Energy harnessed from wind motion. Wind energy is considered to be renewable energy and is o en used to generate electric power. WTI: West Texas Intermediate, a light sweet crude oil used as a benchmark in oil pricing in the US.

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